Inflation Expectations Rise with Fed Action Imminent

Although the next Federal Reserve Open Market Committee (FOMC) meeting is still a week away, the bond market has confidently predicted the result. Monetary policy will be loosened and the committee will engage in another round of quantitative easing (QE2). Fed officials have been arguing in favor of such action for weeks now. They say that unemployment is too high and inflation is too low, so they must act. Well, jobs are still a problem, but inflation no longer appears to be. Inflation expectations have been rising aggressively since the Fed began hinting at action.

Daniel Kruger of Bloomberg reports:

Expectations for rising consumer prices have increased faster in the U.S. than any other bond market this month as central bankers made the case for monetary easing through additional asset purchases. Yields on 30-year Treasuries climbed as much as half a percentage point since September to 2.61 percentage points more than similar maturity inflation-indexed debt, the widest gap since May and an indication for anticipated gains in consumer prices.

In a separate article, Kruger and Cordell Eddings report that inflation-protected Treasuries are drawing negative yields for the first time:

The securities drew a yield of negative 0.55 percent, the same as the average forecast in a Bloomberg News survey of 7 of the Federal Reserve's 18 primary dealers. The sale was a reopening of an $11 billion offering in April.

There are two conclusions to draw from this. First, QE2 has succeeded in raising inflation before even being put in place. The market's expectation for prices is a major driver for how they ultimately change. This implies that deflation won't be a problem after all. If this news is any indication, we'll see higher inflation through the end of 2010 and in early 2011.

Second, the Fed is under even more pressure to follow through with QE2. The market strongly expects action by the FOMC at the upcoming meeting. If it fails to act, then inflation and the stock market will both fall. If there was any doubt in the committee members' minds about whether or not to act, the market has eliminated it. They have little choice.

Now, if it only manages to help unemployment tick down a few percentage points.